Check Clearing System Generally
Individuals, businesses, government agencies, and other institutions of all types issue checks and initiate other electronic transactions to make payments in the United States and internationally. For many years, checks were used almost exclusively in the United States for making payments and today still account for the vast majority of payments (over 95% of payment items). There is a well-defined and well-known process within the banking system of the United States that supports checks as a payment mechanism, commonly known as the check clearing process or check clearing system.
In FIG. 1, Step 1, this process begins when the Payor A1 (individual, company or institution making the payment) prepares and delivers a check to the Payee (individual, company or institution intended to receive the payment). In Step 2, The Payee receives and, where the Payee is a company or institution, processes the check. This typically includes making two accounting entries: entering the amount on the Payee's cash ledger and crediting the ledger account for the Payor. The Payee, Step 3, then deposits the check in its Demand Depository Account ("DDA") at Bank B, also called the Bank of First Deposit.
A Demand Deposit Account ("DDA"), is where a demand instrument (a check) is negotiated (deposited) and settled (check eventually is presented to and accepted for payment by the Payor's bank).
For a large dollar check, the Payee may instruct the Payor to mail the check directly to Bank B to accelerate and safeguard the receipt and deposit of the check, Steps 2.sup.1 and 3.sup.2. This process is called "lockbox" and Bank B in this case would be the lockbox bank.
Bank B processes the check and forwards, Step 4, it to a clearing agent or directly to the Payor's bank, Bank A. The clearing agent or Payor's Depository Institution then gives value to Bank B in the amount of the check, Step 5. The types of check clearing agents are Federal Reserve Banks, correspondent banks (any other bank with which a bank has an ongoing relationship), and local clearinghouses (an arrangement whereby a group of banks located in the same geographic area agree to exchange each others checks for presentment at specified times during each business day).
The clearing agent physically presents the check, Step 6, to Bank A, the Payor's Depository Institution, and subtracts value, Step 6.sup.1, from Bank A for the amount of the check. Before the amount of the check is deducted from the Payor's account, the amount, account number, and other important information must be extracted from the check. The highly automated form of this extraction process performed by banks is commonly known as the check capture process, which is performed differently depending on whether a check is presented by a clearing agent, where the check would be commonly known as an inclearing item, or directly to a branch of Bank A, which is commonly known as a Proof of Deposit ("POD") item.
Highly specialized equipment is needed for capturing inclearing items and POD items. Inclearing items can be captured by high-speed equipment because it can be designed for handling checks only, which are highly standardized in terms of size, shape, paper quality, etc., and because the information will be used solely for debiting DDA accounts. Equipment for handling POD items, on the other hand, must not only have the ability to capture information from checks, but also from deposit slips and other, similar, documents. In addition, other processes must be performed for POD items that require additional specialized capture equipment.
The check capture process, Step 7, performed by the Payor's Depository Institution has two main steps, regardless of whether the checks come from POD or inclearings. First, there is the prime pass capture of information from the Magnetic Image Character Readable ("MICR") line. The first time a check is passed through a bank's capture equipment, it is referred to as the prime pass capture. The MICR line consists of specially designed numerals (E-13B Font) that are printed on the bottom of a check using magnetic ink. As checks pass through a reader/sorter equipment for capture, the magnetic ink is recognized and converted to information that can be used by computers and software for sorting the checks.
A reader/sorter, or sorter, is a machine that magnetically recognizes the MICR line on checks to capture the information encoded there, and also uses the information to sort the checks into pre-specified temporary storage slots. This sorting results in a meaningful grouping of the checks that can be used for further processing. Reader/sorters in use at banks today are highly automated capture devices that can capture up to 100,000 checks per hour. At many banks, these machines have been augmented with cameras to allow for the creation of photographic and digital reproductions of checks as they pass through the sorter.
In the second step in the capture process, MICR line information is used to electronically post (record) a debit against the Payor's DDA. This causes a deduction of the amount of the check from whatever balance exists in the Payor's DDA, just as the Payee's balance in its DDA increased. A special computer system is maintained at Bank A to account for all of these DDA posting transactions and resulting account balances for the Payor's account. When this posting process is completed, the deduction of the amount of the check also is completed, Step 8.
To meet legal and regulatory guidelines, Bank A typically has one day (24 hours or until midnight of the day following presentment) to review the check before approving it for settlement. The check may be returned (not approved) for reasons such as insufficient funds in the account, improper endorsement, stop payment, unauthorized by the Payor, or if the check is fraudulent. Once the check has been properly negotiated, settled and not returned within the one-day legal and regulatory guideline, only one step must be completed in order to complete the check clearing process.
The banks, Step 9, provide a statement of debits and credits to the Payor and the Payee to use for accounting and reconciliation. For the Payor specifically, physical checks, or an acceptable substitute, are returned to the Payor and additional reports for accounting and account reconciliation purposes are delivered to the Payor as well. Account reconciliation is the process of balancing the DDA account to ensure the checks and other items that post against the DDA account match the entries made against the Payor's ledger accounts and that resulting balances match as well. Many banks refer to services designed to support the account reconciliation process as Account Reconciliation Plan ("ARP") services. There is a recurring need for ARP services, so these services are typically provided according to various cycles, which may be a daily, weekly, monthly or some other cycle that best matches a Payor's accounting period.
Electronic and international payments are cleared through other clearing systems, but they all essentially follow the same major clearing steps of negotiation, presentment, settlement, and accounting and reconciliation.
Maintenance of Settled Checks
Once checks and other payments have been settled, all Payors have a common need to store, maintain and utilize or research records associated with each completed payment. In the case of paid checks, Payors also have a need to store, maintain and utilize or retrieve the physical check or a reasonable facsimile of the check.
Records of paid checks and other payments are needed for several purposes, including proof of payment, accounting, account reconciliation, and dispute resolution. These Payor needs are felt especially strongly by businesses, state governments, and other institutions ("commercial customers") that originate a relatively large (250 up to millions of checks per month) number of payments.
In the mid to late 1970's, check volumes were increasing rapidly and the banking industry recognized the need to improve the storage, maintenance and retrieval process for the millions of checks issued each month by commercial customers. A process developed at many different financial institutions, which had different names, but the basic process that created an acceptable substitute for the return of physical checks to commercial customers was called "Film and Index."
This Film and Index process consists of a separate capture pass (recapture pass), which is done sometime after the prime capture pass, most often on a monthly cycle, through which the reader/sorters would photograph (film) the items, assign a new sequence number (a number used for internal bank reference purposes), and associate the check serial number with the new sequence number. The photographs are used to create reproductions of the checks on rolls of microfilm. The sequence numbers and check serial numbers are cross-referenced on a paper report (or microfiche). With this index report, anyone can locate a check on the microfilm independently of the physical checks.
This Film and Index service was a success. It was superior to the more manual process of filing checks and then physically sorting through all the checks to pull the desired items when they were needed. Commercial customers value this process because it is easier and less expensive to retrieve checks, even though it is an imperfect process.
The design of the Film and Index process is straightforward, but many quality control problems are experienced on a regular basis due to the complexity of bank account processing in general. Specifically, the Film and Index process must be performed for multiple customers, which can range up to several hundred commercial customers at a single bank and each customer may have different volumes of paid checks, from only a few hundred per month to several million paid checks per month. Each customer's checks must be stored separately and each customer may have as many as a few dozen bank accounts in which checks must be segregated. Finally, accounts may have different instructions (e.g. because of special industry or regulatory requirements) that require them to be sorted differently or stored in different locations.
When producing ARP services, commercial customer's checks are recaptured by the bank at the end of each cycle, which is usually a monthly accounting cycle. As a result, there are often missing or extra checks (from previous periods, from other companies by mistake, etc.). These two problems exist because checks and related information need to be accessed throughout the accounting cycle by bank clerks for commercial customers and because there is no systematic way to track and control the physical checks. Human error inevitably has occurred despite the best efforts of skilled managers, and until the technology exists and can be effectively applied to ensure better quality control, these problems will not easily be solved.
The quality of photographic images appearing on microfilm presents another quality control issue. Across the industry, commercial customers frequently complain about an inability to read details on checks from the microfilm itself, and printouts of checks from the microfilm are often not very good. These problems often necessitate the need to rerun checks through the process in an attempt to improve the quality. In no case does the clarity of the check copy approach that of the actual check.
Another type of problem with Film and Index is one of timing. Microfilm must be developed like any other film, so there is a certain delay between the end of an accounting period and the time that the microfilm is available for use. There also can be delays in printing the reports. Even after both the microfilm and the index reports are available, there are still problems related to obtaining checks over different or multiple accounting periods. For instance, multiple reports must be searched to locate an item that has paid, sometime, more than a month in the past. This problem only gets worse the further you need to go back in time.
Once the desired item is located on the report, a clerk must find the right roll of film (which might be in use by another clerk), load the film roll, search the roll to locate the item, line up the item for printing, and then print the item. A few print attempts typically are needed to get the contrast settings just right for a better check copy. Once an acceptable check copy has been printed, it must then be prepared for mailing to the person requesting the check copy.
Because this process takes so long, especially after you take into consideration the time the check copy is taking while traveling through the mail system, the requester may get frustrated and unhappy. Though it happens infrequently, if this requester is a vendor of a commercial customer, the vendor may decide to delay shipment of critical supplies. If the requestor is a client of the bank's commercial customer, the person might decide to stop using the commercial customer's service because of poor service. Of course, the excessive time incurred by the commercial customer's own employees as they search for a check on microfilm, and then respond to an inquiry, causes inefficiencies and lost productivity as well.
One other serious shortcoming of the Film and Index process is that commercial customers could only use the check serial number to identify items on the report that they want to see. Since the serial number can be damaged or misread during the capture process, some items can be "lost". Also, by forcing commercial customers to use only the check serial number for locating and retrieving items, they have found it necessary to build other systems and databases to cross-reference the information on the film and index report with other index keys, and to build even more of the same indexing features for electronic payment items as well. They take these actions because index keys that are more relevant to each commercial customer's business are highly preferable to ones assigned by the bank.
Three examples illustrate this limitation. First, in a commercial customer's accounts payable application, their vendors routinely call the commercial customer to ask for information that is not included with the check, which typically is deposited by the vendor's lockbox bank. (See Steps 2.sup.1 and 3.sup.2 of FIG. 1.) Without the check serial number from the check, or other information such as an invoice number or shipping order number, responding to the vendor's inquiry is usually a tedious, time-consuming, and costly process for the commercial customer. Unfortunately, the only way this process could be improved is to link the vendor information with the bank's ARP and other services, which has not been previously possible to do in a reliable, secure, and cost-effective manner.
As a second example, consider a commercial customer that is an insurance company, who will process thousands or even millions of claim requests in a single month. The shear volume of checks necessitates an efficient storage and retrieval system that is easy and as inexpensive as possible to maintain, especially in an era of soaring health costs. To retrieve a claim check, insurance companies want to use a data field that is relevant to the insurance company and their clients, typically the claim number, beneficiary name, or social security number. While microfilm saves on the cost of storing physical checks, microfilm does not provide the desired indexing flexibility.
The third example arises with a commercial customer's payroll processing. Employees contact their employer and request copies of checks for income tax reporting reasons, proof that a check was cashed by them (or another person), and a whole host of other reasons. Requests for check copies and related information may come into the employer from the day after payday through several years after the paid date. Usually, an employee ID or social security number must be used, which is not available with the Film and Index system.
All of the above problems with the Film and Index service are compounded by the fact that usually only one person can perform a search at any one time, unless duplicate sets of reports, film, and the already expensive, specialized equipment needed to view the film are provided. Duplication is not typically a cost-effective course of action, so service and productivity usually suffer.
In the early 1990's, banks began to implement new cameras on their reader/sorters for capturing digital images of checks. New software and related equipment also was developed to make use of the new images. However, the focus of these implementations was on improving internal processes at the bank for Proof of Deposit ("POD") items, and to cut costs of delivering checks and bank statements to individual retail bank customers. For these two applications, only the front side of the check was needed. There was no effort to enhance the process of high-speed check capture for inclearings, nor was there a significant effort to provide images on any media other than for printing on plain paper.
In spite of the development of specialized reader/sorters and new digital image cameras, the need of commercial customers were not being met. For example, to create a viable alternative to replacement of physical checks or film and index, commercial customers must have the backs of checks in addition to the front images. This requirement exists because the endorsement on the back of the check is usually a critical piece of information needed to respond to requests from vendors, employees, etc. Also, commercial customers, with their high volumes of checks, need their check images delivered on something other than paper to derive any value from check images.
Digitally captured images of checks have been used by some banks for limited purposes for commercial customers. In such enhanced check copy systems, the bank passes the checks through check imaging equipment, which stores the check image as well as the sequence number and check serial number, just like the Film and Index service. As with Film and Index, customers request check copies by using a check serial number, only with the new services the image is requested and delivered electronically into a personal computer. While this service eliminated some of the problems associated with Film and Index, it left many of the other problems unsolved.
One reason why these problems cannot be solved by an enhanced check copy system alone is because of the cost of storage of digital images. Storing image items for short periods of time, weeks or months, could be cost-effectively supported, but commercial customers need access to images of checks for up to seven years or more. In addition, to improve upon the standard Film and Index process would require storing information in an index database for seven or more years. Given the tremendous amounts of data that would need to be stored, along with the tremendous computer processing that would be needed to update the index database each day, this process is technically problematic and very costly as compared to the traditional Film and Index process. And as more customers would be added to the bank's database, the problems would only increase in complexity.
One of the most cost-effective media for storing, indexing and retrieving data and images is the compact disk (CD). This media also is quite appropriate for banking purposes because the CD ROM (Read Only Memory) format prevents the alteration of a check, thereby aiding in the use of the image as an accurate reproduction of the check for proof of payment.
The problem with CD ROM's in the early 1990's, however, was that creating or mastering unique CD ROM's for each commercial customer's accounts could only be performed using personal computer-based technology. This technology was too slow to accommodate production of CD ROM's for large numbers of commercial customers in the required time frames. In other words, while technology was available to capture and store (though costly) high volumes of checks, the actual creation of customer-specific CD ROM production was a limitation preventing the widespread usage of CD ROM technology for banking applications.
Commercial customers in the early 1990's were looking into the possibility of creating internal systems for storing and retrieving all of their paper documents, mainly in conjunction with re-engineering efforts that were starting to catch on widely. Even if a company could cost-justify such a system for other reasons, commercial customers still needed a way to include their checks in a manner that was cost-effective and easily maintained. Banks also would need some way to deliver images to these companies. Since it would take hours to transmit even a relatively small number of checks over a regular (telephone) transmission line, that was not a realistic option for all but a handful of companies that could cost-justify high speed transmission lines. As telecommunication costs decrease, as expected over the next few years, transmission of large numbers of images will become more widespread, but only if companies have cost-effective storage and retrieval systems.
Companies also are now interested in finding ways to better control check fraud, mainly because of the rapid rise in check fraud experienced in the late 1980's and early 1990's. Banks for many years have offered services aimed at controlling fraud, such as "positive pay" and "payable thru" (defined below), which provide a way for commercial customers to view the check or check-related information within one day of presentment to the bank. By accelerating the availability of these checks, fraudulent checks can be identified sooner to help prevent many losses from occurring. "Positive pay" is a service where a file of MICR information from the bank is electronically matched against a file of issued item information from the commercial customer. The resulting mismatches are called "exception" or "suspect" items. Exception items are mismatched items that are different for an easily identifiable reason, like the amounts are different due to a bank MICR dollar amount encoding error. Suspect items are mismatches that result from not having an issue record from the commercial customer, which could mean the company made a mistake or that fraudulent items may have been presented to the bank. In either case, the commercial customer needs to review the actual check or check image (front and back).
"Payable thru" is a service performed with paper drafts or checks that are sorted out from the prime pass capture on the day of presentment (the day the check is presented to the Payor's Bank) and picked up by a customer that is near the bank check processing center. Commercial customers review each presented item, including endorsement verification, before making a decision to direct the bank to pay or return each item.
Both the positive pay and payable thru services have a short time window in which to make a pay or return decision. With both positive pay and payable thru processing, a decision to return an item (for fraudulent or other reasons) must be made within 24 hours of presentment to the bank in order to meet many legal and regulatory guidelines.
Problems exist with both positive pay and payable thru processing, mainly because of the short time window for returning items. Commercial customers using positive pay often ask the bank to manually fax photocopies of presented checks, because the MICR line information is not enough on which to make a pay or return decision. This can be a time-consuming, cumbersome, and costly process for the bank. For payable thru, only local customers can take advantage of the service, so the force of competition does not exist in many areas to keep bank prices down and service quality up. Consequently, payable thru service is rarely used today.
As previously discussed, banks also offer Account Reconciliation Plans ("ARP") or account reconciliation services. Banks offer several ARP plans, based on how much of the reconciliation process the customer wants the bank to perform, but the primary service is the full reconciliation service.
Full reconciliation automates the reconcilement of accounts by accounting for and balancing all paid items, all outstanding items, and any mismatches or exception items using a sophisticated computer software system. Outstanding items are reported based on the check issue records received from the commercial customer. Mismatches or exception items are categorized into separate reports in order to better identify the types of exceptions and the follow up action that might be needed to rectify the exceptions. Items include paid checks and electronic items such as wire transfers. Banks perform this service for commercial customers because the systems, expertise, and support needed can usually be performed better by the bank than the commercial customer alone can do.
While an ARP service is a useful process for commercial customers, up to ten business days or more are needed in order for the bank to complete reconciliations for all commercial customers. Commercial customers need to have their accounts reconciled in order to close out their general ledger and to complete their accounting cycle, so any delays, while necessary today, foster a less productive environment than if the customer had a quicker, more efficient way to reconcile their accounts.
Full reconciliation also has traditionally been dependent upon the customer's ability to identify and report specific fields of information in the check issue record. For a relatively small, but still significant, percentage of commercial customers, making investments and performing all the steps necessary to deliver issue records to the bank is not cost-effective or easy to accomplish. Therefore, all the benefits achievable from a full reconciliation are not available to these customers.
Technology exists to potentially capture information directly from checks to create relevant fields of information for indexing, e.g. MICR capture, optical character recognition (using a font such as OCR-A) capture, and digital image extraction, which could eliminate the need for many companies to send issue records to the bank. However, there is no known method in existence to use all of these technologies together. This situation has come about due to the way each capture technology has progressed, similar to the divergence seen with the development of equipment for POD item capture instead of inclearings, and because each technology has focused on problems that have little to do with reconciliation for commercial customers.